Will Crashing Chinese Stocks Mean a Yen Rally?

Includes: EWJ, FXY
by: Darrel Whitten

Lately, every time former Fed chairman Alan Greenspan has opens his mouth he seems to cause shudders in global financial markets because he is taking every opportunity he can to warn that China’s market bubble could burst any day. He is actually being polite.

Professor George Harding of George Washington University has a much bleaker scenario for what could happen if the bubble in China stocks burst and the market crashes.

1. Stocks crash in China
2. Violent protests break out in China's urban areas by indviduals who have lost all their savings in the market
3. China's government panics and declares martial law and suspends reforms
4. China's economy goes stagnant or even contracts short-term

Currency traders profess to be all bulled up to buy the yen when China sells off, but speculative Yen short positions on the CME are back over JPY1.5 trillion, while March saw a 9-year high in capital outflows from Japan of JPY3.8 trillion. The last time these positions were unwound, the yen barely budged as Japanese individual investors were stampeding to buy high yielding investments overseas.

Yen bulls were again frustrated in the February sell-off by individual investors again selling yen to buy offshore investments and corporations locking in on yen positions before the end of the March accounting year. If Chinese stocks really crash, it could trigger repatriation by Japanese individuals who have also been piling into Chinese and Indian stocks. Moreover, the Nikkei 225 has had a correlation (R-squared) of 0.44 with the Shanghai Composit since January 2005, and a 0.86 correlation with India's BSE 30.

When stocks sold off globally last June, the Nikkei 225 was also rallying strongly with India, while China was recovering from a substantial previous sell-off. Now India is lagging and Japan is lagging even worse, even against other OECD markets. Consequently, Japan's Nikkei 225 just might fair relatively better if Shanghai crashes, even if there is more global contagion. Presently, the earnings yield on Japanese equities is a very decent 5.4%, and if you add another 1.1% in dividend yield, Japan is if anything looking relatively cheap.

That said, Japanese ADRs with high US dollar and Euro exposure are the last thing you want to be buying during a yen rally, while a hopes of multiple rate hikes by the BOJ would also be put on ice and thus disappoint investors in Japanese bank stocks who are hoping that higher rates will boost bank profits by expanding loan-deposit spreads.

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